Tax competition or tax harmonization?

Following the last visit to Paris of the German Minister of Finances Wolfgang Schäuble, the French and German governments have decided to harmonize their tax systems. Both sides have emphasised the positive impact that such a harmonization could have on the economic growth in Europe and on the health of the euro.

In particular, it is hoped that the « fiscal dumping » that is supposed to trouble France should hence come to an end; it would be possible for France to (almost) maintain its present level and structure of taxation without strongly penalising the competitiveness of French enterprises.

Since the publication of the famous Primarolo report, it is indeed a common belief that fiscal competition is something damageable; that a fiscal war between EU member States is suicidal and that the economic governance of Europe will be inconceivable as long as taxation remains a matter of national sovereignty. As a matter of fact, it is unquestionable that today’s national taxation policies do not converge.

But is this really damageable for European economies and does it constitute a threat to the European Union? The nature and the scope of divergences are evidenced in the Yearbook on European Taxation 2010 recently published by IREF. According to the report, VAT rates are varying in Europe between 16 and 25%; personal income tax marginal rates jump from 10 to 56% as we cross borders while corporate tax rates fluctuate from a low 10% in Bulgaria to 36.66% in France. Similar gaps are observed between levels the overall tax ratios (i.e. the sum of taxes and social security contributions) of various European countries (e.g., 32% of GDP in Ireland, 58% in France) or levels of public spending (31.5% of GDP in Switzerland, 55.6% in France). Those gaps result not simply from diverging tax rates but also from different tax structures.

As explained in the report, some governments had opted for fiscal and budgetary discipline long before the 2008 crisis. Then, when came the crisis, some, relying on Keynesian policies, have welcomed further pubic deficits and larger debt while others were rejecting them, limiting their borrowing on financial markets. Finally, even older divisions exist between States favouring indirect over direct taxation and those making the reverse choice; or between States taxing preferably corporate revenues and States keen on taxing personal income. Without any doubt, fiscal convergence does not prevail at that point.

So, what should be done? Should we force in tax harmonization or chose tax competition?

So far France and Brussels have explored only the harmonization option, that is, ways to make European member States obey the same European norms. Yet, what should the norms be? France, which, as we know, is not very well positioned in the EU fiscal landscape, would like Europe to adopt the French rules, or at least rates and tax bases near to the French ones. But surely, it is illusory to believe that the other EU members, especially those that do not have the same public spending problems as France, could radically change their policies. The “youngest” European States, for one thing, do not have the legacy of heavy public debt and are embracing gladly tax cuts that seem to them more appropriate to get out of the crisis than an increase of public spending.

Still, do we have to accept “merciless competition” and “fiscal dumping”? As far as we can say, in a way, even States with high debts and high taxes (those are usually going together, except for Spain) have been led towards stricter fiscal policies. Even France, after grumbling at the beginning, is now closer to Germany’s position (even if Angela Merkel’s government is not as rigorous as its coalition partners from FDP would like it to be).

Competition in the field of taxation, as in any other field, forces everyone to align to the best practice. Harmonization, on the contrary, is freezing progress, making innovation and reform more difficult. Many among EU member States are doing their best to lower taxes: some of them have adopted the flat tax that abolishes progressiveness and stimulates economic initiative; others are decreasing tax burden and related charges imposed on firms (they are also reforming social security and pensions, abandoning the pay-as-you-go system); others are pulling the problem out by its roots by decreasing public expenses—something that requires downsizing the State.

We could therefore imagine that a new “harmony” will spontaneously emerge; a harmony built around the principles of lower tax burdens and reduced State interventions. Competition is actually promoting convergence and harmony in a much better way than any government’s “harmonization decree”.